International Business Environment - Foreign Direct Investment PDF

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Foreign Direct Investment...

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Foreign Direct Investment and Theories Foreign Direct Investment (FDI) occurs when a firm invest directly in facilities to produce or market a product in a foreign country. According to the US Department of Commerce, FDI occurs whenever a US citizen, organisation or affiliated group takes an interest of 10% or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. An example is Walmart investing in Japan; Walmart first became multinational in the early 1990s when it invested in Mexico. FDI takes two main forms. The first is a greenfield investment which involves the establishment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country (Walmart’s entry into Japan was through acquisition). Acquistions can be: ● A minority (10 to 49% interest in the firm’s voting stock) ● A majority (50-99%) ● A full outright stake (100%) There is a difference between the flow and stock of FDI. The flow of FDI refers to the amount of FDI undertaken over a given period of time, normally a year. The stock of FDI refers to the total accumulated value of foreign owned assets at a given time. Outflows of FDI is the FDI flowing out of the country and inflows of FDI being the FDI coming into a country. Since World War 2, the US has been the largest source country for FDI, a position it retained during the late 1990s and early 2000s. Other important source countries include the UK, France, Germany, the Netherlands and Japan. This is expected because these countries also predominate in the rankings of the world’s largest multinationals. ● These nations dominate because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many largest and best capitalised enterprises. Firms are bundles of resources under administrative coordination, which produce products for sale in the market for a profit. Their objective, as a firm, is the attainment of the highest possible profit. This is known as ‘profit maximisation.’ Entry Mode: “An institutional arrangement that makes possible the entry of a company’s products, technology, human skills, management or other resources into a foreign country.” (Root, 1987) Non Equity Modes: “NEMs are contractual relationships between TNC’s and partner firms, without equity involvement. Bargaining power represents an additional lever with which TNCs influence their partners and the sources of this power vary by mode.” (WIR, 2011.)

The Four Non FDI Entry Modes Exporting ● ● ●

Involves manufacturing in a different location from the ‘host country’ where products are sold, usually though agents such as local distributors and export management firms. The advantages are it avoids the risk and cost of ‘owning’ operations (manufacturing and sales) in host country. The disadvantages are that manufacturing in the host country may be less costs, high transport costs can make exporting uneconomical and tariff barriers may reduce profits from exporting.

Portfolio Investment ● ● ●

Involves investing is a foreign firm’s stocks, bonds etc. The advantages are that it is only investing in financial assets and it is fairly easy to buy and sell equity securities. The disadvantages are that there is no active involvement in management and therefore no control over management decisions (of the foreign firms).

Licencing ● ● ● ●

Foreign firms sell a ‘licence’ to a local firm on a one time use basis. The advantages are that it avoids cost and risk associated with setting up subsidiary in the host country and it is useful when FDI is restricted. The disadvantages are that it does not ensure tight control over the host country operations and often risks a loss of competitive advantage to other firms. For example, the case of RCA Corp.)

Franchising ● ● ●

Foreign firm sells the ‘trademark’ in exchange for a small percentage of ongoing returns. For example; monthly profits. The advantages are that a firm can build a good global presence quickly and avoid the cost and risk of setting up subsidiaries. The disadvantages are that similar to licencing but less pronounced and there is a lack of control over franchisee for example over quality.

Contractual agreements are long term non equity associations between an international company and an entity in a foreign target country that involve the transfer of technology or human skills from the former to the latter. (Root, 1997). Contractual agreements include licencing, franchising, strategic alliances, turnkey projects and management contracts. Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) reflects a lasting interest and control by a resident entity in one economy in an enterprise resident in an economy, which is different from that of the investor. It involves ownership (either in part or in whole) and management control over a foreign operation. In addition, multinationals can transfer a package of resources to different areas of the world as needed. FDI exerts a significant degree of influence over management. Foreign Direct Investment can be ‘green field’ (a new investment) or ‘brown field’ - an investment through an acquisition of an existing firm. Firms that engage in FDI are called ‘Multinational Enterprises’ or MNEs. Foreign direct investment can occur through joint ventures or wholly owned subsidiaries such as mergers, acquisitions and greenfield investments. FDI Modes of Entry Equity Joint Ventures ●

Particular type of cooperation between firms in which two or more firms create, and jointly own, a new independent organisation. (Besanko 2007). ● Can be minority interests, joint ventures or majority interests. ● The advantages are that is avoids the cost and risk of full ownership, there’s benefit from the local partners knowledge (local marketing) and it is suitable to deal with adverse political risks such as nationalisation. ● The disadvantages are that there is a potential lack of control over transfer of specifically owned technology or know how, there is no full control over subsidiary operations and there are often conflicts in the long term due to differences in national culture or organisational values. Wholly Owned Subsidiaries ●

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Can be split into two types: ○ Greenfield Investments (The majority of FDI) - Used to acquire raw materials, to operation at lower manufacturing costs, to avoid tariff barriers and to satisfy local content requirements. ○ Brownfield Investments (Mergers and Acquisitions) - Used due to their speed of penetration into the market, they allow quick market penetration of the company’s products. Advantages are that they allow full control over protection of technology and provide and increase scope to coordinate globally. The disadvantages are that they are high cost and high risk, they come with increased ‘exit’ costs and with wholly owned subsidiaries there is an increased need to adjust with local corporate culture.

Global FDI Inflows:

By Region:

FDI Outflows:

Trends By Industry:

Summary of FDI Trends: ● ● ● ● ●

FDI is traditionally dominated by the Triad; North America, Western Europe and Japan. Increasing inward and outward FDI in developing nations since the 21st Century. Developmental impact of FDI on both host and home country through capital investment. Shift towards services and away from resource extracting and low tech manufacturing. Reduction of barriers to FDI and incentives to promote FDI.

General Motivations for Foreign Direct Investment ●

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Market Seeking ○ Production close to target customers. ○ Tailor products to individual market requirements. ○ Product is expensive to transport from home economy. ○ Bypass high tariff barriers. ○ Combats adverse exchange rates. Resource Seeking ○ Cheaper production factors - natural resources, labour. ○ Base activities in centres of excellence. Efficiency Seeking ○ Economies of scale and scope. ○ Government incentives.

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Strategic Asset Seeking ○ Gain access to strategic assets. ○ For example, Guanxi networks in China.

Theory of FDI: Dunning’s ‘OLI’ Theory or ‘Eclectic’ Paradigm

The eclectic paradigm was established by the British economist John Dunning. He argues that in addition to the various firm advantages, location advantages are often of a similar importance in explaining both the rationale and direction for FDI. By location specific advantages, Dunning means the advantages that arise from utilising resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets. Dunning accepts the argument of internalisation theory that it is difficult for a firm to license its own unique capabilities and know how. Therefore, he argues that combining location specific assets or resource endowments with the firm’s own unique capabilities often requires foreign direct investment. That is, it requires the firm to establish production facilities where those foreign assets or resource endowments are located. Country/Location Specific Advantages

Firm/Ownership Specific Advantages

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Domestic market size and proximity to export markets.

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Assets

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Industry or product life cycle.

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Knowledge

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Country’s attitude to FDI.

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Information

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Capital and financial markets.

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Networks

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Local talent/skills.

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Size

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Wages costs and labour policies.

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Access to markets.

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Networks (E.g; Chinese businesses.)

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Brands.

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Culture

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Reputation.

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Natural Resources.

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Intellectual Property.

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Cluster of supporting industries.

Internalisation and the theory of Transaction Costs When markets are imperfect, firms create ‘internal’ markets. Licensing may result in giving away valuable technology and know how and it does not give firms the ability to control host country operations that may be important to maximise profitability. A firm may be able to produce products more efficiently than the licensee and therefore gain competitive advantage. The intrafirm exploitation of advantages reduces the cost of information, negotiation, contracting and enforcement of agreements - the transaction costs. Intra Firm advantages such as technological knowledge are like public goods - it is difficult to exclude others from using knowledge once they have it. (Buckley and Casson). OLI and the Firm Specific Advantages (FSAs)/Country Specific Advantages (CSA) Matrix

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branch of economic theory known as internalisation theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets, this is

also known as the market imperfections approach. According to internalisation theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. These are: 1. Licencing may result in a firm’s giving away valuable technological know how to a potential foreign competitor. 2. Licencing does not give a firm the tight control over manufacturing, marketing and strategy in a foreign country that may be required to maximise its profitability. 3. Capabilities are often not amenable to licensing. The future of globalisation, the MNE and FDI: FDI and MNEs are an important force of economic growth but also a potential threat to diversity and equity. WE need to exploit the advantages of MNEs and FDI and offset the disadvantages through appropriate government policies. Entry Mode Comparison

Entry Mode

Advantages

Disadvantages

Exporting

Ability to realise location and experience curve economies

High transport costs Trade barriers Problems with local marketing agents

Turn-key contacts

Ability to earn returns from process technology skills in countries where FDI is restricted

Creating efficient competitors Lack of long-term market presence

Licensing

Low development costs and risks

Lack of control over technology Inability to realise location and experience curve economies Inability to engage in global strategic coordination

Franchising

Low development costs and risks

Lack of control over quality Inability to engage in global strategic coordination

Joint ventures

Access to local partner’s knowledge Sharing development costs and risks Politically acceptable

Lack of control over technology Inability to engage in global strategic coordination Inability to realise location and experience curve economies

Whollyowned subsidiaries

Protection of technology Ability to engage in global strategic coordination Ability to realize location and experience economies

High costs and risks...